Purchasing Power Parity & Fisher Effect Flashcards
Absolute purchasing power parity
The equilibrium exchange rate equals ratio of price levels in both nations
Formula
S = P/P*
S= exchange/spot rate
P= domestic price
P*= foreign price
The Law of One Price
A commodity should have the same price in both countries when expressed in the same currency.
What is this law caused by?
Commodity arbitrage
Why do we need PPP (2)
Exchange rate only reflects when goods are traded,
currencies are traded for other purposes e.g to buy capital assets
Different interest rates, speculation or interventions by central banks can influence the FEM.
(basically exchange rate is subject to other factors, so doesnt make it the best way to measure purchasing power)
Purpose of PPP,
and how does it do this? (2)
Find differences in living standards
- by accounting for:
relative cost of living/inflation
Assumption in PPP theory
No transportation or transaction costs , allowing prices of identification goods to be equal when expressed in the same currency, GIVEN a competitive market)
So given this assumption:
Fluctuations in PPP are due toβ¦
Relative inflation differences
Absolute PPP theory be misleading - what does it ignore (2)
Ignores capital account (capital inflows=BoP surplus AS i.e foreign ownership of domestic assets, capital outflows = BoP deficit i.e investing abroad)
Ignores non traded goods - so Will not even give exchange rate that equilibrates trade in goods and services
Relative purchasing power parity
Exchange rate fluctuation should be proportional to the relative change in the price levels of two nations
Formula
Sβ = Pβ/Pβ / Pβ/Pβ x Sβ
Sβ and Sβ is exchange rates in period 1 and base period
Derivation of PPP
Price index of home country (h) and foreign (f) are equal.
Then, the home country experiences an inflation rate of πΌβ, foreign country experiences If.
What are price expressions now, for home and foreign?
Home price index:
Ph (1 + Ih)
Foreign:
ππ(1 + πΌπ)
If πΌβ > πΌπ (home inflation>foreign) and the exchange rate doesnβt change, where is purchasing power stronger.
- What does this mean for PPP?
Purchasing power is greater on foreign goods (since lower inflation)
- PPP does not exist here. (Since PPP believes E.R adjusts to maintain parity in purchasing power, but hasnβt)
So that scenario looked at inflation, but no exchange rate adjustment to maintain PPP.
If inflation occurs and exchange rate of the
foreign currency changesβ¦
What does the foreign price index from the home perspective become?
ππ(1 + πΌπ)(1 + ππ)
ef is the % change in value of foreign currency
(So same, just added the exchange rate change)
What should ef change to?
Change to a value that maintains parity in the new price indexes of the 2 countries following the inflation
How do we find ππ?
Setting formula for the new price index of the foreign
country equal to home price index.
ππ(1 + πΌπ)(1 + ππ)= πβ(1 + πΌβ)
Then solve for ef
ef =(1+ Ih / 1+ If) - 1
(same formula as forward premium in IRP but inflation instead of interest)
If domestic inflation (Ih) > If , what happens to ef and intuition?
If domestic inflation (Ih) < If , what happens to ef and intuition?
Ef>0 : foreign currency will appreciate to offset the attractive lower inflation which was causing higher demand for currency
Ef<0 : foreign currency will depreciate to offset higher inflation (since they will supply foreign currency causing depreciation)
ef if the inflation differential is small
ef = Ih - If
(Donβt be confused with forward premium if INTEREST DIFFERENTIAL IS SMALL where p = home interest - foreign interest)
Statistical test for PPP
Regression analysis on historical E.R & inflation differentials
T tests to coefficients: if significantly different from expectation, PPP doesnβt hold.
What do empirical studies say about the PPP theory (2)
Relationship between inflation differentials and exchange rates is not perfect. (Exchange rates to not adjust perfectly to maintain parity of the purchasing powers)
However, the use of inflation differentials to forecast
long-run movements in exchange rates is supported
especially where those movements are large.
Reasons why does PPP not occur consistently (2) (why exchange rates do not perfectly adjust to maintain parity following differences in inflation)
Exchange rates are also affected by other factors than just inflation
(e= f(Int, Inf,Inc,GC,EFER)
Lack of substitutes for some traded goods.
So what does PPP work well, less well, not well for
Well for:
Commonly traded INDIVIDUAL commodities
Over long periods of time (flashcard 22 point 2)
Inflationary periods/monetary disturbances
Less well:
All traded goods together
Shorter periods
Periods of monetary stability
Not well:
All goods (non traded goods esp)
Short run
Periods of major structural change
International Fisher effect (IFE) believes what (2)
Countries with higher inflation have higher interest rates.
Domestic real interest rates tend to equal foreign real interest rates
Implications of IFE (2)
Currency with lower interest rates is expected to appreciate relative to the one with a higher rate.
(Since lower interest=lower inflation, so thus this country will sell more exports thus causing appreciation)
interest rate differential is an unbiased predictor of change in future spot rate
What does IFE state the spot rate adjusts to?
Adjusts to the interest rate differential between 2 countries
(So for PPP - exchange rate adjusts for inflation to match parity of 2 price indexes Sβ = Pβ/Pβ/Pβ/Pβ x Sβ)
For IFE - exchange rate (spot rate) adjusts to interest differential (et/eβ = 1 + rh / 1 + rf )
Formula
What if rf is small
πbarπ‘/πβ
IFE = PPP + FE (PPP+fisher effect)
(1 + πβ)π‘
/
(1 + ππ)π‘
- If rf is small
rh - rf = eβ-eβ/eβ
Comparison of IRP PPP and IFE theories
Interest rate parity - based on forward premium and interest rate differential-
should mostly hold due to threat of arbitrage (risk free) profits
PPP - based on trade and inflation differential: exchange adjusts to offset inflation differences across country. holds mainly for large/long term differences
IFE - based on investment and interest rate differential- investing in countries with higher yield (carry trade). So basically IFE means the country with lower interest rates will appreciate since lower inflation. SPOT RATE ADJUSTS TO THE INTEREST RATE DIFFERENTIAL, offsetting the gains from being lower! Offsets by SPICED, reduce exports again
What does empirical evidence find for each parity condition
IRP - holds mostly
PPP and IFE likely to be violated - If held perfectly, inflation (PPP), interest rates (IFE) and exchange rates would have the same variation!
So what is the point of parityβs if theyβre often violated?
Provide markets best guess (still might hold in long run or for large differences)
Simple framework to determine financial linkages between countries
Show economic behaviour well for over LONG HORIZONS (if long, more likely changes are large obvs!)
Why is country risk analysis important
Countrys environment may have adverse impact on forex returns
Country risk likely normal or binary
Binary
E.g government either allows something or not, so 2 options
Pros of country risk analysis (3)
Devise strategy appropriate
Screening device to avoid countries with excessive risk
Revise investment/financing decisions
Political risk factors to consider in country risk analysis (6)
Attitude of consumers - may be very loyal to local products
Government actions - may be protectionist
Potential blockage of fund transfers
Currency inconvertibility - if so, may need to exchange earnings for goods
War
Bureaucracy
Corruption
Financial risk factors
Indicators of economic growth e.g interest rates, exchange rates, inflation etc
Macroassessment vs microassessment of country risk
Macro - risk assessment of a country but doesnt consider MNC
Micro - risk assessment of a country considers the MNC
Ways of assessing country risk
Checklist approach
Delphi technique
Quantitative analysis e.g regression analysis to assess sensitivity of business to risk factors
Inspection visits
Checklist approach: way of assessing country risk
Rating and weighting macro and micro political and financial and factors to create an overall assessment
E.g pg 56 weighting political risk e.g corruption more than financial risk e.g interest rate, inflation
Delphi technique
Collect independent opinions and averaging and measuring dispersion of those opinions
Pg 57
How to compare risk ratings among countries
Foreign investment risk matrix (FIRM)
FIRM
Uses intervals from poor to good, where each country is positioned on the matrix
How can country risk be incorporated into capital budgeting analysis of a proposed project (2)
Adjusting discount rate - higher risk, higher discount
See how cash flows could be affected by each form of risk, to find probability distribution of net present value of the project
